«Contents Executive Summary Executive summary In the current market conditions, businesses are facing their greatest uncertainty for a number of ...»

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09FR-007 How concerned should Directors be about going 30 January 2009

concern?

Contents Executive Summary

Executive summary In the current market conditions, businesses are facing their greatest

uncertainty for a number of years. A reality of such economic

Insolvency issues conditions is that businesses face a higher risk of failure and with that Insolvency and going comes the heightened importance of disclosures around going concern risk. Recent ASIC statements regarding insolvent trading should concern assessments result in directors having a heightened awareness about ensuring their Impact on financial reports entity remains a going concern and avoiding insolvent trading.

and audit opinions This special director’s edition Flash Report addresses some key Director responsibilities questions surrounding the obligations of directors to prevent an entity from trading whilst insolvent and to make disclosures around an Appendix A: Summary of entity’s ability to continue as a going concern.

Regulations on going concern Disclaimer: The information contained herein is of a general nature and is not intended to address the specific circumstances of any particular individual or entity. The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG, an Australian partnership, part of the KPMG International network.

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Insolvency issues When is an entity insolvent?

The Corporations Act 2001 defines solvent as being able to pay all one’s debts, as and when they become due and payable.

A director may be liable for insolvent trading where he has allowed the entity to incur new debts when there are not reasonable grounds to believe that the entity will be able to pay the debts as they become due and payable.

What are the consequences of insolvent trading?

If an entity becomes insolvent there are a number of potential consequences for the entity. A voluntary administrator may be appointed by the directors or secured creditor, the entity may be wound up by the courts, or, in the event there is a secured debt, a receiver may be appointed over the assets of the entity.

In addition, allowing an entity to trade whilst insolvent is likely to have personal consequences for the directors of that entity. The Corporations Act 2001 provides for civil penalties up to $200,000, compensation proceedings and criminal charges with potential penalties of up to 5 years in jail.

Directors should also be aware that pecuniary penalties are not reimbursable under any director and officer insurance.

Since 2004 two directors have been jailed for insolvent trading in Tasmania and Queensland.

When, and over what period, is solvency determined?

Solvency can be a day-to-day issue for entities in financial difficulties or otherwise experiencing downturns. Directors have an obligation to investigate an entity’s solvency throughout a year, not only at reporting dates or when signing solvency resolutions. It is not sufficient to rely on management unless it is a specific requirement of management employment that they advise the board on solvency.

Further, as a consequence of the handing down of the Bell Resources decision in October 2008, directors who agree to the provision of additional security to their banks when there are reasonable grounds to believe that the entity will not be able to pay or re-negotiate the debt may be held personally liable for the debt if they do not place the entity into administration within 6 months of granting the security. This is especially important for directors when renegotiating the entity’s lending facilities for the following 18 months.

At least once, and perhaps twice a year, the Corporations Act 2001 requires directors to make a resolution of solvency, stating that in their opinion there are reasonable grounds to believe that the entity will be able to pay its debts as and when they become due and payable. The directors’ declaration included in annual and half-year financial reports prepared under the Corporations Act 2001 must refer to this resolution.

In making this resolution, directors must ensure that:

• the resolution is made at the date of the directors’ statement, not as at the end of the reporting period. Consequently, the impact of transactions and conditions that have arisen in the intervening period must be taken into account • the prospective period being considered is not limited to only the period until the next directors’ resolution, although this period should be the focus. If conditions exist further into the future which impact the entity’s solvency, then these should also be taken into account.

Insolvency and going concern assessments How is determining solvency different to assessing the going concern assumption?

A key assumption underlying the preparation of financial statements is that the entity will continue as a going concern. An entity is a going concern when it is considered to be able to pay its debts as and when they are due, and continue in operation without any intention or necessity to liquidate or otherwise wind up its operations. Unlike the day-to-day assessment of solvency, directors assess an entity’s ability to continue as a going concern each time financial statements are approved for issuance – annually for all entities under the Corporations Act 2001 and half-yearly for listed entities.

Over what period is going concern assessed?

There is no consistent definition of the period over which the assessment of going concern must be made.

Under Australian Accounting Standards, the assessment must be for at least the 12 months from the reporting date although it could be a longer period.

Under Australian Auditing Standards, auditors must make that assessment based on the 12 months from the date that they sign the audit report, which is typically a couple of months after the end of the financial year.

Both the accounting and auditing standards also require that directors examine a period beyond the 12 month period if there is significant doubt about the entity’s ability to continue as a going concern.

What factors should be taken into account when assessing the ability to continue as a going concern?

A detailed analysis may not be required if an entity has a history of profitable operations, there is little concern that the entity will continue to be profitable, and the entity has ready access to financial resources. In the present environment, however, it may be more difficult to support these assumptions.

Directors should satisfy themselves that management have actively considered the extent to which past history can be assumed to continue.

Factors to consider include:

• the degree of uncertainty about a future event or condition will increase as the period until that event or condition is expected to occur, or remain, increases • judgements about the future are made at a point in time, but facts and circumstances may change such that the original judgement proves to be invalid. An assumption that was made in the last going concern assessment may not remain valid for the current assessment • larger and more complex entities, and those more greatly impacted by external factors, are entities that will require significantly more judgments about the outcomes of future events and conditions.

What evidence should directors consider around solvency and going concern?

The types of evidence that need to be provided to indicate that an entity can continue as a going

concern include:

• cash flow projections that show an ability to pay debts as and when they fall due that factor in realistic assumptions in the current market conditions, including if current conditions deteriorate further • detailed business plans covering the period under consideration • evidence that the business model adopted is sustainable in current conditions, or the strategies that are in place to adapt the model to current market conditions • support for the entity’s ability to obtain new funding upon the maturity of existing funding arrangements • evidence that debt covenants have been assessed and any risk of breaching them has been managed, such that they do not provide significant risk • asset valuations if asset sales are a relevant mitigating factor in determining solvency or going concern • assessment of the ability of the entity to pay any guarantees made and the likelihood of the guarantees being called on.

What if the bank will not confirm that a facility will be renewed in the future?

In current economic conditions banks are often reluctant to provide confirmation that facilities will be renewed at a future rollover date. In addition, certain Australian branches of overseas banks may decide that they do not want to continue some or all of their Australian business lending operations, such as with the withdrawal of automotive financing entities. However, management may still be able to demonstrate to directors that this does not indicate that the entity is no longer a going concern. This

could include demonstrating that:

• the entity is currently in positive negotiations to renew the facility with the bank, until the process is completed • the bank has a policy of not confirming future renewals • the entity has just renewed the facility • management plans to maintain adequate cash flows through other means, such as equity raisings, sales of non-core assets, postponing planned expenditures, or reducing overhead and administrative expenses.

Impact on financial reports and audit opinions How does the going concern concept impact the accounts preparation process?

Directors may come to one of four different conclusions with respect to the ability of an entity to continue as a going concern.

1. The entity is considered to be a going concern, and there are no material uncertainties that lead to significant doubt over its ability to continue as a going concern.

2. There is material uncertainty around the ability of the entity to continue as a going concern, but mitigating factors exist, and are sufficiently disclosed, which lead to the conclusion that the entity will continue as a going concern. Mitigating factors could include the ability to sell assets, the availability of alternative forms of financing, or the ability to reduce or postpone expenditures, among others.

3. There is material uncertainty around the ability of an entity to continue as a going concern, which is not sufficiently reduced by mitigating factors.

4. The entity cannot be considered a going concern, and it is inappropriate to prepare accounts on this basis.

How do these going concern outcomes affect the audit report?

The following flow chart outlines the different scenarios that a business may find itself in with regards to going concern and the resulting audit outcomes.

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